Understanding Theta Decay in Options

Theta reflects a change in the value of an option when it is nearing its expiration date. In this case, the value drops. This is true in all cases for theta decay options if everything else stays constant.

Options let us buy or sell a given asset at the “strike price” that we first agree upon when acquiring the option. But as the calls puts options near their expiration date, their profitability also decreases.

This is because the window of time before they can be exercised is shorter.

When the time comes, you’ll have to sell/buy the security associated with the option — this is called option assignment.

How does this tie in with theta decay?

Let’s find out!

What is Theta Decay in Options Trading?

As mentioned earlier, in theta decay options, the given options lose value (which they will inevitably) as they move near their expiration date. If you plan to long a call option, theta decay is inevitable.

The closer an option moves to the expiration date, the more it loses its value.

This, of course, is true for the buyer, while the opposite is true for the seller. As an option nears expiration, it makes sense to sell it, making it a profitable trade, but this is not true for the buyer. For this reason, when someone sells an option (as the value increases for the seller), it is called a positive theta trade

Tips to Avoid Option Assignment When Trading Theta Decay

When you get your hands on some options, the goal is to exercise them at some point, i.e., buy or sell the underlying security. But as the expiration date draws near, you may not be able to exercise the option if prompted.

Here comes the important part: how to avoid option assignment in such a situation.

When you are long put options, you must sell the underlying security at the strike price when the buyer asks you to exercise your option. This is called option assignment. But if you want to avoid this, you can hold the option without exercising it (for a minor loss). Or if you have sold it, you can buy it back.

Neither strategy is ideal, but it saves you from a bigger loss.

How to Read an Options Chain for Theta Decay Opportunities

Next up: how to read options chain?

Reading the options chain to understand the rate at which an option loses value over time is as simple as things get, even if it doesn’t sound that way. The theta value is always a negative figure (i.e, let’s say -0.02).

This value reflects the loss in value per day, which means that if the theta is -0.02, the option loses the corresponding amount (in dollars) per day. These losses, as we mentioned earlier, can become greater as an option long call nears its expiration.

Feel free to explore a couple of theta decay graphs to get a basic understanding of how things work.

Long Call and Long Put Options: Impact of Theta Decay

As long option terms inch nearer to the expiration date, the option loses value to theta decay at an accelerated rate. All long options suffer to a greater extent by options theta decay if everything else remains constant.

The loss in value gets greater and greater as the option’s timeframe becomes shorter and shorter. This is because the associated sense of urgency skyrockets when the expiration date draws near, i.e., what to do with the option?

Using Option Iron Butterfly to Manage Theta Decay

Many traders, when they spot the opportunity to do so, can even benefit from theta decay options.

This is made possible by the option iron butterfly technique.

In this case, a trader buys four options, two call and two put, at three strike prices and the same expiration dates. The idea is to profit from the devaluation of the options when the stock prices remain relatively stable.

That’s a wrap from our side; happy trading to you all!


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